Mission Concluding Statement 

Luxembourg: Staff Concluding Statement of the 2025 Article IV Mission

March 21, 2025

• While fundamentals remain strong, Luxembourg’s economic performance has been lackluster during 2022-24. A tepid recovery is underway, supported by public consumption. But there are risks of setbacks stemming from weaker external demand and higher financial market volatility, alongside domestic challenges in the real estate sector and fiscal pressures.
• The near-term policy mix should focus on securing a more private sector-led recovery, addressing confidence issues in the real estate sector and better anchoring fiscal policy in a medium-term perspective to enhance policy predictability.
• As the recovery takes hold, policy makers should focus on enhancing resilience of the economy through i) a prudent fiscal policy that efficiently addresses spending pressures by balancing fiscal discipline with strategic needs, ii) tax reforms to diversify fiscal revenues and reduce revenue uncertainty, and iii) a more flexible labor market. At the same time, the macroprudential framework and stance need to be strengthened to safeguard the resilience of the financial sector and borrowers.
• In parallel, accelerating reforms that tackle challenges from aging, low productivity growth, labor and housing supply constraints, and housing affordability, would better position Luxembourg to benefit from the ongoing transformation of the global economy and durably sustain living standards.

Recent developments

Luxembourg’s fundamentals and policy buffers remain strong amid consecutive shocks. GNI per capita is one of the highest in Europe. Buoyant fiscal revenues have financed generous support packages while maintaining relatively low public debt and ample —albeit declining— fiscal space. The large financial sector has weathered the recent shocks well, and the 2024 FSAP found it sound and well-diversified.

But economic performance in recent years was weaker than projected with a tepid recovery underway. Based on data for first three quarters, GDP growth is estimated at ½ percent in 2024, below the EA average for the third consecutive year, despite a strong boost from public consumption. Outside the public sector, employment growth has been sluggish, and the unemployment rate has continued to rise, surpassing the long-term average of 5½ percent. Demand for mortgages started to recover in 2024H2 and house prices have stabilized, but demand for new construction remains weak. Credit growth to the nonfinancial private sector has remained negative due to subdued demand, ongoing deleveraging by households and firms, and tighter credit standards for firms. Mainly driven by nonfinancial firms, banks’ asset quality has deteriorated, though it remains at manageable levels.

Several factors contributed to this slow recovery, in addition to the monetary policy tightening. High private sector indebtedness and past house price overvaluation contributed to a substantial but orderly correction in the real estate market, heightened uncertainty, and low confidence in the construction sector. At the same time, automatic wage indexation contributed to labor costs rising faster than in peer countries while productivity has been declining, potentially reducing Luxembourg’s competitiveness. Demand-focused support policies helped smooth recent shocks, but were less effective in creating a momentum in the economy and may have created moral hazard.

Outlook and Risks   

The recovery is expected to gain pace. GDP growth is projected to rebound to about 2 percent in 2025 and accelerate further to about 2½ in 2026-27, driven by the private sector. This reflects the baseline assumptions of lower interest rates and a return of confidence in the housing market, as well as significant pent-up domestic demand. The recovery in the labor market would be slower due to the unwinding of labor hoarding. The phasing out of electricity price controls in the beginning of this year will temporarily increase inflation to about 2¼ percent. Under unchanged policies, the fiscal deficit is projected to widen and debt to steadily increase amid spending pressures from defense, aging, climate and other investment needs. Meanwhile, the main drivers of the increase in revenue in recent years—exceptional bank profitability and an increase in the labor income share—are projected to wane.

Downside risks prevail. In 2025, headwinds stem from weaker external demand and higher global financial volatility due to geoeconomic uncertainties and trade actions. Domestically, challenges in the real estate sector could adversely affect the recovery. In the medium term, higher defense and infrastructure spending in trade partners as well as progress toward the EU capital markets union could boost growth. Yet, benefiting from these hinges on Luxembourg addressing structural issues related to competitiveness, housing affordability, and labor supply. Moreover, fiscal risks remain high, arising from substantial revenue uncertainty due to a concentrated taxpayer base and reliance on revenue from nonresidents, and that can be affected by other countries’ tax regimes. There are also implicit contingent liabilities from the financial sector, mitigated by the resolution framework. Demographic trends pose risk to long-term fiscal sustainability through spending pressures on health and pensions.

Fiscal Policy

With the continued normalization of the ECB’s monetary policy, a neutral fiscal stance would be appropriate in 2025. After contracting in 2024—mainly due to under execution in spending—fiscal policy is projected to be expansionary this year. Moreover, the shift from temporary support measures to permanent tax cuts and higher spending will widen the underlying deficit. Staff caution against further delays in unwinding remaining discretionary measures and encourage any revenue overperformance or underspending to be saved. This in turn would deliver a more neutral stance, appropriate in light of households’ strong financial position and expected further monetary easing. Staff also note that income-support measures are likely to be less effective, given high saving rates and low fiscal multipliers. Reliance on existing automatic stabilizers (e.g., unemployment benefits) would be sufficient.

Going forward, staff considers that the authorities should guard against growing spending pressures and revenue uncertainty by balancing fiscal discipline with strategic needs. Spending pressures can be accommodated without a significant increase in debt, by containing current expenditure growth of the central and local governments and avoiding a further narrowing of the tax base.

• On spending, staff welcome the authorities’ expenditure path in the Medium-term Structural Fiscal Plan (MTSFP), which incorporates a reduction in current spending excluding social security expenditures to enable some increase in capital and interest spending. It is essential to underpin this reduction with clearly defined measures. These should include ways to contain the wage bill growth, including by leveraging ongoing digitalization trends, rationalize tax expenditures, and better target social spending.
• On revenue, tax reforms should aim at reducing revenue uncertainty. It should be budget-neutral or compensated by other measures, such as by diversifying revenues through higher property or environmental taxation and excise taxes. The planned modernization of the direct tax administration is welcome; it could bolster long-term revenue performance and reduce delays in tax collection, especially in corporate taxes, thus helping reduce revenue volatility.

A national fiscal rule would enhance credibility and reduce policy uncertainty. Staff support the authorities’ plan to implement a national rule, as the EU current framework is less restrictive for Luxembourg. This would affirm a commitment to maintain Luxembourg’s AAA rating, better anchor fiscal policy, and importantly incentivize efficiency gains. The new rule should ensure long-term sustainability while keeping flexibility to deal with shocks and accommodate investment needs. Staff recommend a debt anchor combined with an operational fiscal rule, which could be based on fiscal balances, multi-year expenditure ceilings, or an expenditure rule. In parallel, the role of the fiscal council should be strengthened to develop its own macro fiscal projections, risk assessment, and debt sustainability analysis.

These efforts should be enhanced by modernizing the budgeting framework. Staff see a need to improve fiscal statistics and reporting, strengthen revenue performance analysis and projections, and revamp fiscal risk assessment. On the expenditure side, greater transparency, including through a proper costing of policies and systematic explanations of deviations from the budget, would enhance accountability. Finally, performance-based budgeting, regular spending review including for public investment or ex-post assessments of policies would enhance efficiency and effectiveness.

The authorities’ consultation on pension reform is timely and welcome. While the system’s reserves are substantial, under current policies pension expenditure is projected to grow significantly, exceeding income from contributions already next year, and pension reserves are expected to be depleted by [2045] amid a large increase in the old-age dependency ratio. Enacting pension reforms early on would provide time for a gradual implementation of the needed adjustment. To ensure the long-term sustainability of Luxembourg’s pay-as-you-go pension system action is needed on several fronts. Reforms need to focus on disincentivizing early retirement, increasing retirement age, and reducing the generosity of the pension system. Increasing contribution rates will further help with putting the pension system finances on a more sustainable footing, albeit the potential adverse impact on labor market and labor costs should be carefully considered.

Financial sector policies

The financial sector is overall well positioned to weather shocks with some pockets of vulnerability. The financial sector is resilient, with well-capitalized and liquid banks: The Commission de Surveillance du Secteur Financier (CSSF) and FSAP stress tests show sufficient loss-absorption capacity on aggregate in a downside scenario. Cyclical systemic risks remain moderate as at time of the 2024 Article IV. Under staff’s baseline of restored confidence in the real estate sector, the recent rapid increase in nonperforming loans for resident real estate and Small and Medium Enterprises (SMEs) in domestic banks should not have a major impact on credit supply. Given the domestic banks’ large exposure to this sector, corporate and real estate vulnerabilities should continue to be closely monitored Investment funds’ liquidity risks seem manageable, and leverage is relatively low except for hedge funds. Staff welcome increased scrutiny of investment funds’ linkages with other financial intermediaries.

Household indebtedness could become a concern in the medium term. Despite decline in the debt-to-income ratio, households’ indebtedness is still elevated and the debt service-to-income on new mortgages has remained high at 44 percent, even as maturities lengthened. Credit risk could resurface should unemployment rise more than expected, although high assets and savings and automatic stabilizers would buffer against adverse income shocks.

Prudential policies should thus remain agile. The current level of the countercyclical capital buffer (CCyB) is broadly appropriate, given the expected turn in the credit cycle – alongside the need to maintain releasable buffers to absorb potential losses. The relevant supervisory authorities should continue to ensure sufficient loss absorption capacity, including through adequate provisioning of expected losses and scrutinize credit risk management and collateral valuation practices. Looking forward,

• If the credit cycle turns decisively, the authorities should consider increasing releasable buffers, preferably through sectoral systemic risk buffers (or by gradually increasing the CCyB and formalizing the positive neutral CCyB framework to enhance its effectiveness). Additionally, to CSSF’s existing interest rate stress test on households credit worthiness, income-based measures to tackle high households’ indebtedness and improve borrowers’ resilience should be introduced, along with a gradual reduction of the maximum LTV limit of 100 percent.
• The authorities are urged to work with banks and the industry to address the sources of lack of confidence in real estate companies (e.g., by reforming the completion guarantee scheme) and consider contingency measures in case confidence does not return.

Staff welcome the commendable progress in implementing the 2024 FSAP recommendations on bank and investment funds supervision. Staff encourage strengthening the macroprudential and financial safety net frameworks. The macroprudential governance framework should be bolstered by reducing the Ministry of Finance’s role in decision-making, enhanced communication, and coordination with other policies (e.g., housing policy). Staff encourage a better integration of systemic risk assessments due to high interconnectedness, including by enhancing data collection on other financial intermediaries and analyzing their linkages with investment funds and banks. While welcoming progress on liquidity supervision, by finalizing the memorandum of understanding between BCL and CSSF), the authorities should continue to strengthen the financial safety net framework.  Finally, with increasing risks of cyberattacks and use of AI, resilience to operational risks should continue to be strengthened. Building on ongoing efforts, the authorities should further enhance the monitoring of money laundering/terrorist financing risks of cross-border flows, including through further exchange of information with domestic and foreign authorities.

Long-standing structural challenges

A comprehensive set of structural reforms is vital to boost private-led growth and sustain living standards. Luxembourg’s growth in past decades was driven by a rapidly expanding labor force, mainly immigrants and cross-border workers, while labor productivity growth has lagged peers. This is not sustainable given a rapidly ageing population and infrastructure bottlenecks, including insufficient housing supply. Frontloaded policy action is needed across several dimensions.

Greater labor market flexibility is essential for resilience. The automatic wage indexation system needs more flexibility to help firms cope with shocks. Collective bargaining reforms should be done in a way that does not hamper labor mobility within and across sectors given low job-to-job transition rates. Reducing entry requirements to professional services while preserving quality would boost competition and benefit the business sector.

Labor supply needs to adapt to evolving market needs. The recent law facilitating labor market access for third-country nationals is welcome. Further efforts should focus on incentivizing labor market participation of seniors and reducing the gender gap through enhancing work flexibility and switching to individual taxation. Financial incentives could be considered to encourage firms to hire and retain senior workers through life-long learning and other age-management practices. The progress in addressing skills mismatches, including via increased provision of training, is welcome.  

Restoring housing affordability through supply-side measures is key to reducing cost of living and preserving competitiveness. Staff welcome the recent streamlining of building permits. Moreover, careful calibration and implementation of land tax reform to mobilize unused land is paramount. Investing in mobility and encouraging firms’ presence near borders would ease pressure on hubs. At the same time, demand-side measures, such as interest payment deductibility from income tax, should be gradually withdrawn, starting with those directed to investment properties.

Enhancing innovation and technology adoption could boost productivity. The recent SMEs digital support program will help moderating productivity dispersion between frontier and laggard firms through better innovation diffusion within sectors. Reducing the regulatory burden for SMEs, providing targeted incentives, and investing in infrastructure will help catalyze private sector investment in intangible assets, and R&D spending. The upcoming AI strategy is welcome, but harnessing the potential of AI requires tackling persistent labor shortages in the IT sector though agile labor and education policies. In addition to domestic reform, advancing reform at the European level to tackle barriers to entry in the service sector could further drive productivity growth.

The IMF team would like to thank Luxembourg’s authorities and other interlocutors for their warm hospitality and for constructive and insightful discussions.